Lucian Bebchuk is James Barr Ames Professor of Law, Economics and Finance, and Director of the Corporate Governance Program, at Harvard Law School. Kobi Kastiel is Research Director of the Program’s Project on Controlling Shareholders and Assistant Professor at Tel-Aviv University Faculty of Law. This post is based on their recent study, available here.

Dropbox filed IPO documents last week, and our analysis of these documents reveals considerable risk that the company’s co-founders would hold lifetime control even if they would retain only a tiny minority of the company’s equity capital. In a study that we just placed on SSRN, The Perils of Small-Minority Controllers, we seek to place a spotlight on a significant set of dual-class companies whose structures raise especially severe governance concerns: those with controllers holding a small minority of the company’s equity capital.

We analyze the perils of small-minority controllers, explaining how they generate considerable governance costs and risks and showing how these costs can be expected to escalate as the controller’s stake decreases. We also identify the mechanisms that enable such controllers to retain their power despite holding a small or even a tiny minority of the company’s equity capital. Based on a hand-collected analysis of governance documents of these companies, we present novel empirical evidence on the current incidence and potential growth of small-minority and tiny-minority controllers. Among other things, we show that governance arrangements at a substantial majority of dual-class companies enable the controller to reduce his equity stake to below 10% and still retain a lock on control, and a sizable fraction of such companies enable retaining control with less than a 5% stake.

Finally, we examine the considerable policy implications that arise from recognizing the perils of small-minority controllers. We first discuss disclosures necessary to make transparent to investors the extent to which arrangements enable controllers to reduce their stake without forgoing control. We then identify and examine measures that public officials or institutional investors could take to ensure that controllers maintain a minimum fraction of equity capital; to provide public investors with extra protections in the presence of small-minority controllers; or to screen midstream changes that can introduce or increase the costs of small-minority controllers.

Below we provide a more detailed account of our analysis:

Snap, the owner of the disappearing-message application Snapchat, went public last March at a valuation exceeding $20 billion. The company used a multiple-class structure that would enable its young co-founders, Evan Spiegel and Bobby Murphy, to have lifetime control of the company. Following the initial public offering, Spiegel and Murphy owned a substantial fraction of Snap’s equity capital—about 18% each. Our analysis of Snap’s IPO structure indicates that it would enable the co-founders to unload an overwhelming majority of their shares—lowering their economic stakes to less than 1% of the company’s equity capital—and still retain control. Notably, however, Snap’s offering documents omitted this crucial fact.

Similarly, Facebook, Snap’s larger and older rival, went public in 2012 with a dual-class structure that placed significant limits on the ability of its founder, Mark Zuckerberg, to reduce his fraction of equity capital without relinquishing control. In April 2016, however, Facebook passed a reclassification plan, approved by Zuckerberg’s majority voting power, that would have enabled Zuckerberg to sell two-thirds of his Facebook shares—reducing his stake of equity capital to about 4% and possibly less—without losing his controlling voting power. In September 2017, however, Facebook announced its decision not to proceed with the reclassification plan for the time being, and Zuckerberg currently continues to face significant limits on his freedom to unload shares without losing his control.

In our paper, we focus on such situations — dual-class structures that enable controllers to have a lock on control with only a small or even a tiny fraction of the company’s equity capital. In the long-standing debate on dual-class structures, both proponents and opponents have often lumped all dual-class structures together into one category. By contrast, we seek to reorient the debate by stressing certain key differences among dual-class structures.

Dual-class structures generally enable a shareholder to retain a lock on control with less than a majority ownership stake. Dual-class structures thus commonly enable what the literature labels as a “controlling minority shareholder” (Bebchuk-Kraakman-Triantis (2000)). In our paper, however, we focus on the subset of controlling minority shareholders whose stake is not merely a minority stake, but rather a “small-minority” stake (defined as below 15% of equity capital), a “very-small-minority” stake (below 10%) or even a “tiny-minority” stake (below 5%). Controllers holding such stakes pose enhanced governance risks relative to other controlling minority shareholders, and therefore they deserve the close attention of public officials and institutional investors.

The analysis of our paper is organized as follows. Part II begins by discussing the long-standing and heated debate over dual-class structures and how we aim at contributing to it and reorienting it. We then turn to explain why structures with small-minority controllers can be expected to produce considerable governance risks and costs. In companies that are widely held, the market for corporate control and the threat of replacement incentivizes corporate insiders to serve the interests of public investors. In companies with a majority owner, the disciplinary force of the control market does not operate, but the controller’s ownership stake forces the controller to bear the majority of the effect of his choices on total market capitalization, and thus provides strong ownership incentives that align the controller’s interests with those of public investors. By contrast, a company with a small-minority controller lacks both the discipline of the control market and the incentives generated by having to bear a majority of any effect on total market capitalization.

We show how the decisions made by small-minority controllers can be expected to be distorted across a wide range of corporate choices—including allocation of opportunities and talents, decisions whether to remain as the CEO, choices of strategy and company scale, related-party-transactions, and responses to acquisition offers. In each of these contexts, we show, there is a substantial risk that the choices of small-minority controllers would be significantly distorted.

Part III of our paper identifies and explains the operation of mechanisms that are used to enable shareholders to retain control despite owning only a small minority of the company’s equity capital. Furthermore, using a hand-collected dataset of governance arrangements in dual-class companies, we provide empirical evidence about the incidence and use of these mechanisms.

The mechanisms that Part III analyzes include (i) “hardwiring” provisions granting the controller the ability to elect a majority of board members, or to cast a fixed fraction of votes, regardless of how small the controller’s equity stake might become; (ii) a large difference between the voting power of high-vote and low-vote shares; (iii) nonvoting shares, which represent an extreme case of infinitely high ratio between the voting power of high-vote and low-vote shares; (iv) arrangements aimed at limiting the consequences that stock sales by the controller could have for the controller’s lock on power; and (v) arrangements aimed at constraining the consequences that high-voting shares held by third parties could have on the controller’s lock on power.

Part III also analyzes midstream changes, such as nonvoting stock reclassifications, that can be used to amend existing governance arrangements to enhance the controller’s ability to unload shares without relinquishing control. We show that the future use of such nonvoting stock reclassification could enable controllers to reduce their ownership stakes to negligible levels without weakening their grip on control.

Part IV presents novel empirical evidence, based on our hand-collected dataset of governance provisions in dual-class structures, on the incidence of small-minority, very-small-minority, and tiny-minority controllers. Importantly, we analyze not only current equity stakes but also the extent to which controllers would be able to reduce their equity stakes in the future without relinquishing control. Existing governance provisions plant the seeds for future increases in the separation between control and ownership stake, so we also analyze the minimum equity stake that the controller at each company would need to hold to retain control.

We find that, in a sizable fraction of cases, the governance provisions in place would enable the controller to hold less than 5% of the equity capital (and thus be a “tiny-minority controller”) and still retain control. Furthermore, in a substantial majority of cases, the governance provisions in place would enable the controller to hold less than 10% of the equity capital (and thus be a “very-small-minority”) and still retain control. Finally, in an overwhelming majority, the governance provisions in place would enable the controller to hold less than 15% of the equity capital (and thus be a “small-minority controller”) and still retain control.

Part V discusses the implications of our analysis for future policymaking and capital market practices. To begin, public officials and institutional investors should recognize the substantial governance risks associated with small-minority controllers. The extent to which governance arrangements can be used to expand the “wedge” ¾ the gap between the controller’s fraction of voting rights and his fraction of equity capital ¾ is commonly not transparent to investors. Thus, disclosure rules should require companies to provide such information. In assessing the extent to which dual-class companies pose governance risks, public officials and institutional investors should play close attention to the existing and potential level of the wedge.

Furthermore, we identify and discuss arrangements that could be used to address the current and future presence of small-minority controllers. Institutional investors could press for or encourage the introduction of such measures, and public officials could consider using their legal and regulatory tools to ensure a uniform adoption of such measures. Here we discuss three types of arrangements: (i) arrangements aimed at limiting the extent to which controllers can lower their ownership stake without weakening their lock on control; (ii) arrangements aimed at providing additional protections to public investors in situations where small-minority controllers would remain in control; and (iii) arrangements aimed at preventing midstream changes, such as nonvoting stock reclassifications, that would introduce or exacerbate the governance costs of small-minority controllers.

Before proceeding, we should note that some corporate law scholars oppose any limits on the structures that companies going public may offer to investors. The debate on contractual freedom in corporate law is long-standing and raises general questions that go beyond the scope of this paper. While we subscribe to the view that it is desirable to place some constrain on IPO choices, as existing corporate and securities law do, this paper does not seek to repeat the arguments for this view or otherwise to contribute to the debate on contractual freedom. However, because we recognize that some readers could well support in principle allowing companies to go public with any structures they choose, we wish to stress that our analysis should be of interest even to such readers.

To be sure, such readers would not support requiring dual-class companies to adopt governance provisions that place any limit on the size of the stake that controllers would be required to have to retain control. However, the main contribution of our paper, and one which should be of interest even to such readers, is to provide an understanding of the governance risks posed by small-minority controllers. To the extent that such risks are significant, even such readers should recognize the benefits to public officials and institutional investors of understanding these risks. Obtaining such an understanding would be essential for facilitating the introduction of private-ordering arrangements that would serve the interests of public investors; for judicial application of an appropriate level of scrutiny to controller actions; and for the development of disclosures that would provide adequate transparency of the risks posed to public investors and would help IPO investors to price these arrangements accurately.